Climate change impact on financial institutions

After the UN conference in Paris last year, it is increasingly clear that financial institutions need to take action on climate change. But how exactly will this issue affect financial institutions, and what actions can and should be taken, as the severity and frequency of events gathers pace? Sharanjit Paddam and Kate Mackenzie discuss these challenges for Australia

Australia and many other countries will see an increase in tropical diseases, which will result in significant changes to our health needs and how our healthcare is funded, including private health insurance

In 2014, Henri de Castries, chairman and CEO of AXA, said: “Climate risk for us is neither an ideological or theoretical issue: it is a core business issue, as we are already seeing the impact of increasing weather-related disaster risks. Extreme weather events are increasing in intensity and severity. Last year alone, AXA paid out over €1bn globally in weather-related insurance claims.”

De Castries’ comments provide an important perspective on climate risk – it is fundamentally a financial and economic risk to financial institutions. So it is not surprising that regulators are taking an interest. Mark Carney, governor of the Bank Of England, and chairman of the Financial Stability Board, stood in front of the Lutine Bell at Lloyd’s of London – the spiritual home of insurance – and announced to the assembled captains of the industry that climate change was real: “The combination of the weight of scientific evidence and the dynamics of the financial system suggest that, in the fullness of time, climate change will threaten financial resilience and longer-term prosperity.”

Carney’s comments speak directly to the nature of climate risk – it is a systemic and pervasive risk. The Prudential Regulation Authority’s (PRA) recent paper on The Impact Of Climate Change On The UK Insurance Sector, spells out the three key ways climate change poses a risk to financial institutions:

Physical risks – the impacts today on insurance liabilities and the value of financial assets, which arise from climate and weather related events, such as floods and storms that damage property or disrupt trade

Liability risks – the impacts that could arise tomorrow if parties who have suffered loss or damage from the effects of climate change seek compensation from those they hold responsible. Such claims could come decades in the future, but have the potential to hit carbon extractors and emitters the hardest – and, if they have liability cover, their insurers

Transition risks – the financial risks that could result from the process of adjustment towards a lower-carbon economy. Changes in policy, technology and physical risks could prompt a reassessment of the value of a large range of assets as costs and opportunities become apparent.

Transition risksTransition risks are perhaps the most complex of these three mechanisms, as they often arise as secondary effects, and rely on a chain of events in order to pose a risk for the industry. For example, consider the risks of investing in carbon-intensive industries. The International Energy Agency has noted that: “No more than one-third of proven reserves of fossil fuels can be consumed prior to 2050 if the world is to achieve the ‘less than 2 °C’ goal, unless carbon capture and storage (CCS) technology is widely deployed”.

Investors in fossil fuel industries either assume that their assets will be among the one-third that gets burned; or that governments will not take significant action to restrict emissions from fossil fuels; or that the as-yet unproven CCS technology will take off. Even Bayes would have trouble stringing together the probabilities on that one.

The PRA report also makes it clear that the later any emissions reductions take place, the faster the economy will have to transition away from fossil fuels, and the more likely we will have a disorderly transition, with associated sudden drops in asset values.

Climate then poses a risk to financial institution investments, particularly where those investments are in carbon-intensive industries. However, this is not the only risk to investment values from a transition to low-carbon economies.

Battery storage technology is poised to disrupt both the energy generation and the energy distribution sectors. Here in Australia, a home without rooftop solar panels is becoming a rarer and rarer sight. If this is combined with the take-up of batteries, most homes would be able to disconnect from the grid entirely. So even green energy distributed through poles and wires faces a threat from even newer technology.

Physical risksThe agricultural sector is also exposed to climate risk. Changing climate will change the viable regions for different plant species, and also the distribution of pests and diseases. This is already having an impact on Australia’s wine industry.

Australia and many other countries will see an increase in tropical diseases, which will result in significant changes to both health needs and how our healthcare is funded, including private health insurance. This will be exacerbated by increased deaths from heat waves.

As ocean temperatures continue to rise with the changing climate, we will also see changes to the distribution of marine life. Today in Australia, the northern Great Barrier Reef is over 90% bleached, and 35% already dead. Not only is this a devastating loss in itself, but the impact on our tourism industry will be significant.

Physical risks are already an issue worldwide. The PRA report notes increasing evidence of an increase in the frequency and severity of weather related events. Out of all the developed nations in the world, Australia is the most exposed to natural disaster risks. Climate change will lead to sea-level rises that will increase the threat of cyclones, floods and storm surges to coastal property.

As those threats increase, insurance becomes unaffordable and eventually properties become uninsurable. In a worst-case scenario, this may well trigger a drop in property values, and increased defaults on mortgages. Climate risk transforms to credit risk, and the resulting losses to bank assets could well rival the worst of the financial crisis.

The property sector is likely to be increasingly exposed as cyclones start to move further south, into areas that do not have building standards designed to withstand them.

Ultimately, we will see demographic change as people relocate in response to climate change. This will result in changes to our infrastructure needs, and the value of existing infrastructure assets. As well as living elsewhere, people will work in different industries, disrupting employment patterns.

So how significant will this be? The mining, construction, housing, health, manufacturing, agriculture, tourism and energy sectors make up nearly 50% of gross value added in the Australian economy. While it is unlikely that the full 50% of these sectors will be exposed to climate risk, other sectors such as financial services will also be affected by climate risk through secondary effects.

Liability risksThe PRA report has much to say on liability risks arising from climate change, and especially the potential similarities to the way asbestos liabilities emerged in the past. Predicting the outcome of legal decisions is not for the fainthearted. However, the potential for a single court decision to open the floodgates on further claims cannot be ruled out.

Responding to climate changeUp to now, we have seen a limited response to climate change from financial institutions here in Australia. Much of the response has been about corporate and public relations rather than an integrated risk management strategy.

Under an enterprise risk management framework, the starting point in managing any risk is identification and measurement. It is unclear if banks, insurers and other financial institutions have begun quantifying their risk, because there has been very little detailed disclosure to date. The FSB’s Climate Related Financial Disclosure Taskforce is developing a framework for disclosure. While this is likely to be a voluntary disclosure in the short run, it is very likely that they will become compulsory as climate risks become climate events, and regulators are forced to take action.

There is an opportunity for financial institutions to establish credibility with investors and customers, and a competitive advantage by actively managing their exposure to climate risk through an integrated climate risk strategy.

The tools available to financial institutions are rapidly increasing in sophistication. Here in Australia, a website has been launched to enable home owners to assess their risk to coastal flooding: coastalrisk.com.au/. The website includes detailed maps and climate scenarios allowing users to understand the risks posed.

Financial institutions are already exposed to climate risk. Banks have already written mortgages for homes that are exposed to increasing coastal erosion. Life insurers have already sold policies to people who may see their health deteriorate and mortality increase.

Paradoxically, general insurers who write short-term policies are likely to be the least exposed to physical risks, as they have the option of walking away. However, when the vast majority of residential housing in Australia is close to the coast, general insurers will face decreasing revenues as well as increasing claims. And that is before we even consider the reputational damage to insurers from leaving sections of the community without coverage.

An integrated climate risk strategy would allow banks to explore mitigation strategies. These could include defensive underwriting, whereby lending criteria start to exclude highly exposed properties. For properties where there are viable resilience measures, such as retrofitting cyclone protection, banks can offer loans to their existing customer base to fund adaptation measures.

Investors, such as pension funds and life offices, can also consider the financing of new technology – for example, loans to fund the installation of solar panels, new infrastructure investments, and green bonds to finance renewable energy. Bloomberg recently estimated that the current fossil fuel industry consists of $5trn in assets. That’s a huge opportunity for new investment.Sharanjit Paddam is principal, actuaries and consultants, Deloitte Australia, and Kate Mackenzie is manager, investment and governance at The Climate Institute

Sharanjit Paddam is principal, actuaries and consultants, Deloitte Australia, and Kate Mackenzie is manager, investment and governance, at The Climate Institute